Anthony Hilton: Executive bonuses damage growth

Thursday 13 December 2012 10:19 BST

Cash

Back in 2000, Andrew Smithers wrote a book called Valuing Wall Street which tried even at that early stage to puncture the impression that Federal Reserve chief Alan Greenspan was the fount of all wisdom because of the damage it did by encouraging complacency about asset prices. Nobody paid much attention at the time.

Today, Smithers’ concern is the executive bonus culture unforeseen and the unappreciated damage it inflicts on the wider economy. Again no one wants to listen.

His most recent paper published last week is a case in point. It may be little surprise to laymen but most economists are mildly embarrassed by how hopelessly wrong most contemporary economic forecasts are — and particularly those on which the Government relies. But, Smithers says, one reason things don’t work out as they expect is that economists use models which take no account of changes in behaviour.

These have come about thanks to the present craze for trying to align executives’ interests with those of the shareholders by paying massive bonuses linked in one way or another to increases in earnings per share, the return on equity and the share price.

There are four puzzles in the current economic downturn. Inflation is persistently high, unemployment is surprisingly low, and investment is the worst it has been for years while labour productivity has dropped off a cliff. Smithers’ simple explanation for all these surprises is that corporate behaviour has changed as a result of the perverse incentives of the bonus culture.

We shouldn’t be surprised. If we pay people millions to do something then the chances are they will do it. But until economic forecasting models are changed to account for this change in behaviour they will continue to come up with the wrong answers.

There is no doubt that British business has been under-investing in recent years. Just the other day, Robin Chater, secretary-general of the Federation of European Employers, noted that capital replacement in the UK has fallen more than in any other European country since 2005. In the seven years up to 2012 it dropped from 16.6% of GDP to just 14.5%. However, in Germany it rose from 17.3% to 17.8%, in Sweden from 17.9% to 18.9% and in France from 19.3% to 20.2%. “The UK is turning into an old-style Third-World country,” he said, “with low pay growth for most workers below managerial level, widening pay differentials and poor levels of capital investment.”

Note that Chater’s start point is 2005, which was three years before the collapse of Lehman. Apologists for business say that firms are not investing because of the uncertainty caused by the economic crisis. Chater points out that under-investment was an issue three years earlier.

Smithers’ core argument is that the bonus system gives executives the incentive to use cash to buy back shares rather than buying new plant and equipment, because the former gives an immediate boost to earnings per share, whereas the latter is more likely to depress it and add to costs in the near term. It also prompts executives to push up prices to keep profit margins high even when demand is weak and even though, in the longer term, both activities weaken the business and make it vulnerable to competition. Many will find this a more convincing explanation of our persistent inflation than the one put forward yesterday by the Bank of England’s Spencer Dale.

Normally, high profit margins are a signal that companies will invest and grow but not when the effect on bonuses is factored in, because this creates a built-in bias against investment and towards inflation. Nor are they called to account by shareholders because they are part of the problem. The professional investors who manage most people’s savings don’t object because they are thinking short term too. It is only the real owners of the companies and the country as a whole that suffers but they don’t have a voice.

The same pressures account for the unusually high employment and collapse in productivity. When a business experiences an increase in demand it is biased towards pushing up overtime or taking on more employees even if this is significantly less efficient than buying additional plant. This is because the cost of capital experienced by management is different from the cost of capital experienced by the business — and this, as has already been pointed out, is because the managers’ personal financial interest is advanced by using capital to finance share buybacks but damaged by using it to buy plant and equipment. As different bits of the economy ebb and flow, the willingness to take on labour and not replace plant means that rising levels of employment become compatible with a stagnant level or output.

Add in the fact that higher-than-expected inflation and lower-than-expected investment both damage the growth prospects of the economy and you solve why forecasters keep getting the numbers wrong, employment is surprisingly high and the economy is going nowhere.

Smithers has been saying this now for some time but thus far has failed to get a debate going on the damaging behavioural change brought on by bonuses. It is unsustainable if we want an economy which is even half way efficient. But the arguments are uncomfortable — so no one wants to listen.